PART A

Question 1:
Given:

 Average risk = Beta = 1

 Treasury bond rate = 2%
 Generate revenue = 60% of US and 40% of Mexico
 Risk premium = 7.5% in Mexico and 5.5% in US

Required:

 Company’s cost of equity = ?

Formula:

Cost of Equity = Risk-free Rate + Beta * Equity Risk Premium

So, Weighted Average equity risk premium = 7.5%*40% + 5.5%*60%

= 6.3%

Put this value in formula of cost of equity = 2% + 1*6.3%

Cost of equity in USD= 8.3%

Question 2:
Given:

 Expected return = 16%

 Risk free return = 10%
 Expected return of portfolio = 15%

Required:

 How much invest = ?

Formula:
Weight of Risky Asset = (Expected Return of Portfolio - Risk-Free Rate) / (Expected Return of
Risky Asset - Risk-Free Rate)

= (15% - 10%) / (16% - 10%)

=5% / 6%

= 0.83%

So, weight of risk free asset in portfolio = 1 - Weight of Risky Asset

= 1 – 0.833

= 0.167 = 16.7%

So, we invest 16.7% in risk free asset and 83.33% in risky asset

Question 3:
Given

 Cash flow 1 year = £60

 Cash flow 2 year = £50
 Beta = 1.75
 Risk free rate = 8%
 Risk premium = 12%

Required:

 Accept or reject project =?

Formula:

Cost of Capital = Risk-Free Rate + Beta * Equity Risk Premium

= 8% + 1.75* 12%

= 8% + 21%

= 29%
Year 1 PV = £60 / (1 + 29%)^1 = £46.51

Year 2 PV = £50/ (1 + 29%)^2 = £30.05

Total PV = £46.51 + £30.05 = 76.56

NPV = £76.56 - £100 = -£23.44

NPV is negative, so, we should reject the project.

Question 4:
Given:

 Initial Investment = £1000

 Annual Net Cash Flow = £500
 Discount rate= 8%

Required:

 Minimum life of project = ?

Formula:

PV of NCF = NCF x (1 - 1 / (1 + r)^n) / r

Year 1 = £500 x (1 - 1 / (1 + 8%)^1) / 8% = £462.96

Year 2 = £500 x (1 - 1 / (1 + 8%)^2) / 8% = £891.63

Year 3 = £500 x (1 - 1 / (1 + 8%)^3) / 8% = £1,288.55

NPV = £891.63 - £1000 = - £108.37

NPV is negative in Year 2 and Positive in year 3, So, the minimum life is 2 years

Question 5
Given:

 Investment = 100€
 Rate = 5% compounded monthly
  Future Value = 120€

Required:

 Time = ?

Formula:

FV = PV x (1 + r/n)^(n*t)

120€ = 100€ (1 + 0.05/12)^12t

120€ = 100€ (1+ 0.004167)^12t

1.2 = (1. 004167)^12t

Taking natural logarithm

Ln1.2 = Ln(1. 004167)^12t

0.182 = 12t Ln (1. 004167)

0.182 = 12t (0.004158)

t = 0.182/0.0499

t = 3.64years

Question 6
Given:

 Beta of A = 1.4
 Beta = 1.9
 Weightage = 10%

Required:

 New beta = ?

Formula:

Β(new) = β(A) x (1 - w) + β(project) x w

= 1.4*(1-0.1) + 1.9*0.1

=1.4*0.9 + 1.9*0.1

Β(new) = 1.45

Question 7
Given:

Year 0 1 2 3 4 5

NCFs -£17,500 £3,455 £5,600 £5,600 £5,600 £2,945

 Discount rate = 5%

Required:

 NPV = ?

Formula:

PV = CF / (1 + r)^t

Year 0 = -£17,500 / (1 + 0.05)^0 = -£17,500

Year 1 = £3,455 / (1 + 0.05)^1 = £3,290.48

Year 2 = £5,600 / (1 + 0.05)^2 = £5079.37

Year 3 = £5,600 / (1 + 0.05)^3 = £4837.49

Year 4 = £5,600 / (1 + 0.05)^4 = £4607.13

Year 5 = £2,945 / (1 + 0.05)^5 = £2307.48

NPV = -17500 + 3,290.48 + 5079.37 + 4837.49 +4607.13 + 2307.48

NPV = 2621.95

NPV is positive, so project should be accepted

 Question 8
Gold prices and stock prices would likely be inversely correlated if a cartel of gold-producing
nations varied their gold production in line with the UK stock market in the manner that has been
described. Gold production would decrease in response to a rise in the stock market, which
would result in a decrease in the supply of gold and a rise in its price. On the other hand, if the
stock market went down, more gold would be produced, which would increase the supply of
gold and lower its price.

Your current holdings and portfolio diversification will determine how this will affect your
portfolio. The decrease in gold supply could help your portfolio if you already have a significant
exposure to gold investments. On the other hand, a decrease in stock prices would have a
negative impact on your portfolio if it is heavily invested in stocks.

To help lessen the impact that changes in the market have on the value of your portfolio as a
whole, it is essential to have a diversified portfolio that includes a mix of stocks, bonds, and
alternative assets like gold.

Question 9
(a) The bond's price would go down if the current yield on corporate bonds increased. This is
because a bond's price is inversely correlated with its yield. Investors are willing to pay less for a
bond when the yield rises because they want a higher return on their investment. On the other
hand, when the yield falls, the bond's price rises because investors are willing to pay more for the
bond to get the lower yield.

b) The price of government bonds is likely to rise in a macroeconomic environment that is

negative, such as a recession. This is due to the fact that in times of economic uncertainty,
government bonds are typically regarded as a safe investment. Investors tend to shift their
investments away from riskier assets like stocks and toward safer assets like government bonds
when the economy is struggling. Even though government bonds have a low yield, their price
rises due to increased demand.

In addition, central banks may lower interest rates in times of economic uncertainty, which may
also raise the cost of government bonds. This is on the grounds that securities with better returns
become more appealing to financial backers when loan fees are low, which builds the interest for
those bonds and drives up their cost. Overall, lower interest rates and increased demand for safe-
haven investments may cause the price of government bonds to rise in a negative
macroeconomic environment.

Question 10:
Given:

 Expected return = 10%

 Standard deviation = 7%
 Confidence interval = 68%
 Confidence interval = 95%

Required:

Comment = ?

(a) A 68% confidence interval can be determined by adding and deducting one standard
deviation from the normal return. Accordingly, the 68% confidence interval for the actual return
of the investment is:

Expected return ± Standard deviation = 10% ± 7% = [3%, 17%]

(b) A confidence interval of 95 percent can be calculated by adding and subtracting 1.96 standard
deviations from the expected return, which accounts for 95 percent of the possible outcomes.
Therefore, the following is the 95% confidence interval for the investment's actual return:

Expected return ± (1.96 x Standard deviation) = 10% ± (1.96 x 7%) = [-3.72%, 23.72%]

These confidence intervals indicate the range within which we can be reasonably confident that
the investment's true return will fall. Expected return = 10% (1.96 x Standard deviation) = [-
3.72%, 23.72%] The greater the confidence interval, the more uncertain we are regarding the
investment's actual return. Because there is more uncertainty associated with a higher level of
confidence, the 95% confidence interval is wider than the 68% confidence interval in this
instance. It is essential to keep in mind that although these confidence intervals provide some
indication of the degree of uncertainty surrounding the investment's return, they do not guarantee
any particular outcome.

Question 11:
Given Data:

Company A B C

Expected Return 0.11 0.09 0.16

Standard Deviation 0.23 0.27 0.50

Correlations A B C

A 1 -0.20 0.25

B -0.20 1 -0.30

C 0.25 -0.30 1

 Weights equally = 1/3

Required:

Standard Deviation of equal weights = ?

Formula:

Portfolio Variance = wA^2 * σA^2 + wB^2 * σB^2 + wC^2 * σC^2 + 2 * wA * wB * ρAB * σA

* σB + 2 * wA * wC * ρAC * σA * σC + 2 * wB * wC * ρBC * σB * σC

Portfolio Variance = (1/3)^2 * 0.23^2 + (1/3)^2 * 0.27^2 + (1/3)^2 * 0.50^2 + 2 * (1/3) * (1/3) *
(-0.20) * 0.23 * 0.27 + 2 * (1/3) * (1/3) * 0.25 * 0.23 * 0.50 + 2 * (1/3) * (1/3) * (-0.30) * 0.27 *
0.50

Portfolio Variance = 0.03638

Standard Deviation = Sqrt 0.03638

Standard Deviation = 0.515446 = 51.55%

 Question 12
Given:

Case 𝐸(𝑅𝑗) 𝑅𝑓 𝛽 𝐸(𝑅𝑚)

1. 21% ? 1.1 20%

2. 19% 4% ? 14%

3. 17% 6% 0.65 ?

Required:

 Find missing cell?

Formula:

𝑅𝑓 = 𝑅𝑚 + 𝛽(𝐸(𝑅𝑗) − 𝑅𝑚)

Case 1:

Rf = 20% + 1.1(21%-20%) = 0.211 = 21.1%

Case 2:

4% = 14% + B (19% - 14%)

4% = 14% +5%B

B = (4%-14%)/5%

B = -2

Case 3:

6% = Rm + 0.65(17% - Rm)

6% = Rm + 0.1105 – 0.65Rm

-5% = 0.35Rm
Rm = -0.14286 = -14.27%

Case 𝐸(𝑅𝑗) 𝑅𝑓 𝛽 𝐸(𝑅𝑚)

1. 21% 21.1% 1.1 20%

2. 19% 4% -2 14%

3. 17% 6% 0.65 -14.27%

Question 13:
(a) We want the two assessments since they depend on various models, and each has its own
suppositions and constraints. The CAPM equation uses the current market conditions and the
stock's beta to estimate the expected return, whereas the regression equation uses historical data
to estimate the relationship between the stock's returns and market returns. By looking at the two
appraisals, we can evaluate whether the stock is exaggerated or underestimated comparative with
its normal return given the ongoing economic situations and the stock's risk level.

(b)

Given:

 Company S beta regression = 0.95

 Regression constant = -0.024
 R2 = 0.73
 𝑅𝑀𝑎𝑟𝑘𝑒𝑡 = −2.5%
 Risk free rate = 3.3%
 Regression equation = Estimated return = -4.8%
 CAPM = Estimated return = -2.2%

Required:

Jensun’s Alpha = ?

Formula:
Jensen's Alpha = Actual return - Expected return

Jensen's Alpha = Actual return - Expected return Jensen's Alpha = Actual return - (-2.2%)
Jensen's Alpha = Actual return + 2.2%

We do not have information about the actual return of the stock in February 2023, so we cannot
calculate the Jensen's Alpha at this point. However, if the actual return is lower than the expected
return based on the CAPM equation, the Jensen's Alpha will be negative, indicating that the
stock underperformed relative to its expected return given its risk level.

(c)

Based on the Capital Asset Pricing Model (CAPM), Jensen's Alpha is a measure of an
investment's excess return in relation to its expected return. The CAPM uses an investment's
beta, which measures how sensitive the investment's return is to changes in the return on the
market, to estimate its expected return.

Jensen's Alpha will be positive for a company that has outperformed market expectations if its
actual return is greater than its CAPM-estimated return. This suggests that the company has
outperformed expectations in terms of returns given its beta's level of risk.

On the other hand, a negative Jensen's Alpha indicates that the business has underperformed
market expectations if the actual return is lower than the CAPM-estimated return. This shows
that the organization has created returns that are lower than what might be generally anticipated
given its degree of chance.

Based on the company's actual return and the expected return based on the CAPM, we can
determine whether the company has outperformed or underperformed market expectations by
calculating Jensen's Alpha.

Question 14
Given:

 Standard deviation = 40%

 Expected return = 20%
 Riskless asset expected return = 10%
(a) The risk-free asset would be the place to put all of an investor's wealth if they wanted a
complete portfolio with no standard deviation. This is because investing in the riskless asset
eliminates all risk because it does not have a standard deviation.

(b) The risky market portfolio would receive all of an investor's wealth if they desired a complete
portfolio with a standard deviation of 40%. This is on the grounds that consolidating the
hazardous market portfolio with the riskless resource won't change the standard deviation of the
total portfolio, so the financial backer can accomplish the ideal standard deviation by putting
altogether in the dangerous market portfolio.

c) A risk-free asset portfolio would receive 25% of an investor's wealth and a risky market
portfolio would receive 75% of an investor's wealth if the investor desired a total portfolio with a
standard deviation of 20%. The ratio of the risky market portfolio's desired standard deviation to
its standard deviation is used to calculate the proportion of investments in the risky market
portfolio:

Proportion in risky market portfolio = (desired standard deviation - standard deviation of riskless
asset) / (standard deviation of risky market portfolio - standard deviation of riskless asset)
Proportion in risky market portfolio = (0.33, or 33%) Proportion in risky market portfolio

(d) The risky market portfolio would receive 125% of an investor's wealth if the investor desired
a complete portfolio with a standard deviation of 45%. This is due to the fact that combining the
risky market portfolio with the riskless asset will reduce the standard deviation of the entire
portfolio. As a result, in order for the investor to achieve the desired standard deviation, they will
need to invest more than one hundred percent of their wealth in the risky market portfolio. The
ratio of the desired standard deviation to the total portfolio standard deviation is used to calculate
the proportion of investments in the risky market portfolio:

Proportion in risky market portfolio = (desired standard deviation - standard deviation of riskless
asset) / (standard deviation of complete portfolio - standard deviation of riskless asset)
Proportion in risky market portfolio = (45 percent - 10 percent) / (40 percent - 10 percent)
Proportion in risky market portfolio = 1.17, or 117 percent. As a result, the investor would need
to borrow an additional 17 percent of their wealth at the risk-free rate in order to achieve the
portfolio that
e) The CAPM equation can be used by an investor who wants a complete portfolio with a 15%
expected return to figure out how much of their wealth to put into the risky market portfolio:

The investor would invest 50% of their wealth in the risky market portfolio and 50% in the
riskless asset to achieve the desired expected return. The expected return of the entire portfolio is
equal to the proportion in the risky market portfolio. The expected return of the risky market
portfolio is equal to the proportion in the risky market portfolio. The expected return of the
riskless asset is 15%. The expected return of the risky asset is equal to the proportion in the risky
market portfolio.

Question 15:

Question 16:

(a) To calculate the new D/E ratio under each option, we need to find the new amounts of debt
and equity after each option:

Option 1:

 New stock issued = $1 billion

 Half of outstanding debt repurchased = $6,000/2 = $3,000 million
 New debt issued = $3,000 million
 New total debt = $6,000 million - $3,000 million + $3,000 million = $6,000 million
 New equity = $8,000 million + $1,000 million - $3,000 million = $6,000 million
 New D/E ratio = $6,000 million / $6,000 million = 1

Option 2:

 New debt issued = $1 billion

 Stock bought back = $1 billion
 New total debt = $6,000 million + $1,000 million = $7,000 million
 New equity = $8,000 million - $1,000 million = $7,000 million
 New D/E ratio = $7,000 million / $6,000 million = 1.17
Option 3:

 New debt issued = $3 billion

 Stock bought back = $3 billion
 New total debt = $6,000 million + $3,000 million = $9,000 million
 New equity = $8,000 million - $3,000 million = $5,000 million
 New D/E ratio = $9,000 million / $5,000 million = 1.8

(b) To calculate the after-tax cost of debt under each option, we use the formula:

After-tax cost of debt = Pre-tax cost of debt x (1 - Tax rate)

Option 1:

Pre-tax cost of debt = 13%

After-tax cost of debt = 13% x (1 - 40%) = 7.8%

Option 2:

Pre-tax cost of debt = 15%

After-tax cost of debt = 15% x (1 - 40%) = 9%

Option 3:

Pre-tax cost of debt = 20%

After-tax cost of debt = 20% x (1 - 40%) = 12%

(c) To calculate the cost of equity for option 3, we use the CAPM formula:

Cost of equity = Risk-free rate + Beta x Equity risk premium

 Risk-free rate = 8%
 Beta = 1.2
 Equity risk premium = 5.5%

Cost of equity = 8% + 1.2 x 5.5% = 14.6%

Note that for option 3, we do not need to adjust the beta for the increased financial risk since the
beta already reflects the increased risk from the higher debt level.

Question 16:
WACC is a generally involved instrument for assessing capital planning choices. It is the typical
expense of the organization's capital, weighted by the extent of every part in the organization's
capital design. The WACC is much of the time utilized as a rebate rate to decide the net present
worth (NPV) of an undertaking, which helps in going with choices in regards to capital planning.

The WACC takes into account the costs of both equity financing and debt financing, which are
the two most common forms of business financing, which is one of its main benefits. It shows
how much capital investors would need to make an investment in the company's projects.
Subsequently, it gives a thorough and comprehensive perspective on the organization's expense
of capital, considering both the gamble and return of various wellsprings of supporting.

Be that as it may, there are a few impediments to involving the WACC as a device for capital
planning. The WACC assumes a constant capital structure, which is not always the case in
practice, which is one of its limitations. By repurchasing existing securities or issuing new debt
or equity, businesses frequently alter their capital structure over time. Thus, the WACC may not
precisely mirror the genuine expense of capital for a task, especially in the event that the
organization's capital design changes essentially over the long run.

The WACC's assumption that all projects carry the same risk as the company's current operations
is another limitation. But this might not always be the case. A few ventures might have
sequential gamble than the organization's current tasks, which might influence the necessary
pace of return and the NPV of the undertaking. As a result, depending on the risk profile of
specific projects, the WACC may need to be modified.
 PART B
Question1

Stocks Beta
A 1.063392
B 0.884517
C 0.776698
D 0.767746
E 1.119031

Range from less risky to high risky

Stocks Beta
D 0.767746
C 0.776698
B 0.884517
A 1.063392
E 1.119031

Question 2:
Yes, I confirm the results that you obtained from the regressions regarding the beta values, by
using an excel function to compute beta.

Stock A:

Coefficie Standa
nts rd Error t Stat P-value
 -
Interce 0.0002 0.7024 0.4824
pt -0.00016 25 9 35
X
Variabl 0.0246 43.159 1.7E-
e1 1.063392 39 44 307

Stock B:

CoefficieStanda
nts rd Error t Stat P-value
Interce 0.0003 1.5967 0.1104
pt 0.000606 79 75 37
X
Variabl 0.0414 21.335 3.19E-
e1 0.884517 57 85 93

Stock C:

Coefficie Standa
nts rd Error t Stat P-value
-
Interce 0.0002 0.5507 0.5818
pt -0.00015 64 4 59
X
Variabl 0.0288 26.883
e1 0.776698 91 75 1E-140

Stock D:

CoefficieStanda
nts rd Error t Stat P-value
Interce 0.0002 0.6350 0.5254
pt 0.000133 09 14 75
X
Variabl 0.0228 33.577 1.1E-
e1 0.767746 65 04 205

Stock E:

Coefficie Standa
nts rd Error t Stat P-value
 Interce 0.0003 1.2713 0.2037
pt 0.000399 14 38 22
X
Variabl 0.0342 32.639 3.4E-
e1 1.119031 85 21 196

Question 3:
The lowest Beta value is 0.767746 of stock D.

Less Risky
0.08
0.06
0.04
f(x) = 0.76774552186464 x + 0.000132854143009973
R² = 0.30206100090648 0.02
0
-0.06 -0.04 -0.02 0 0.02 0.04 0.06
-0.02
-0.04
-0.06
-0.08
-0.1
-0.12